How are interest rates calculated

Whether you're saving or borrowing money, it pays to learn about how interest rates work. Find out more in our guide.

What is an interest rate?

Interest is what a bank will pay you to save with them and what you pay a lender for borrowing from them. It’s usually shown as a percentage on savings and lending products.

 

Keeping an eye on interest rates can be a good idea. When it comes to your savings, the higher the interest rate, the more money you’ll earn in interest. But a higher interest rate on lending products (e.g. a mortgage or credit card) could also mean it's more expensive to borrow money.

What is the Bank of England base rate?

The base rate or Bank Rate – is set by the Bank of England (BoE) and is usually reviewed every 6 weeks.

 

It sets the rate of interest paid to commercial banks for any money they hold with the BoE. Banks then consider the base rate amongst other factors when deciding the amount of interest they pay to you for saving with them, or how much it charges you to borrow money on a loan, credit card or mortgage.

How is interest calculated on a savings account?

The value of interest you get on your savings is calculated from the balance you have in your account.

There are two types of interest rates:

Fixed interest rates

Fixed interest rates are set and can’t be changed by the Bank for the duration of the agreed term. When you open a fixed rate savings account, you can put money away for a set amount of time at a fixed rate.

This can be useful as you’ll know exactly what interest rate to expect. You won’t be hit by any changes to interest rates if the base rate drops, but you also won’t be able to move your money around if interest rates rise.

Find out more about the first direct Fixed Rate Savings Account. You must have a first direct current account to open a savings account with us.
Fixed Rate Savings Account

Variable interest rates

Variable interest rates can go up or down – so the rate you got when you opened your savings account could change. Your bank will let you know in advance if this happens.

If the BoE rate changes, it’s likely your interest rate will change too.

A change in interest rate can affect how much interest you earn on your savings.

How does interest work on a savings account?

The bank pays you a percentage of interest on the money you have in your account. It’s a reward for saving money with them.

 

When you open a savings account, you should be told the interest rate and whether it’s fixed or variable. It’s important to check the terms and conditions of your savings account. There may be terms you need to follow to make the most of any interest or other benefits. 

How often is interest paid on a savings account?

Interest on a savings account is paid to you monthly or yearly, depending on the type of account you have. When you’re paid the interest is based on the terms of your savings account. Check the terms and conditions of your account for full details.

What is compound interest on savings?

Compound interest is where you earn interest on previously earned interest. It may sound like a riddle, but understanding compound interest can help your savings grow faster.

 

For example, if you had a savings balance of £1,000 with a 5% AER/gross interest rate (calculated yearly), you’d earn £50 in your first year, making your new balance £1,050.

 

Then in the second year you’d earn interest on the balance of £1,050, meaning the balance at the end of year 2 could be £1,102.50.

 

The longer you save for, the more compound interest you can make.

*This example is based on a fixed rate savings account where interest is accrued annually

AER stands for annual equivalent rate. This shows you what the rate would be if interest were paid and compounded each year. 

Gross is the rate of interest paid before any tax (where applicable) has been deducted.

What about AER & APR?

There are some terms you may have heard about.

 

AER – is the annual equivalent rate. It takes into account compound interest to help you compare different savings accounts.

 

APR – is the annual percentage rate on borrowing. It helps you understand the cost of the credit and to compare similar products.

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